COST OF CAPITAL

“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult
ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.”
—Karl Marx.
After reading this chapter, students should be able:
 To define and calculate the component costs of debt and preferred stock.
 To explain why the cost of debt is tax adjusted and the cost of preferred is not.
 To explain how to compute the weighted average cost of capital and its component costs of
capital.
 To describe how a firm attempts to find a minimum cost of capital by varying the mix of its
sources of financing.
 To understand the advantages and disadvantages of financing through debt and equity.
 To understand the role played by taxation and floatation costs in calculating the cost of capital
or weighted average cost of capital.
 To identify some of the factors those affect the WACC.
 To list some problems with the estimation of cost of capital.

The cost of capital is a term used in the field of financial management which represents the
cost at which a company’s fund were acquired, taking into account both debt and equity
sources of funds. It is the rate that must be earned in order to satisfy the required rate of
return from an investment.

The weighted cost of capital or WACC is the hurdle rate the firm should use to evaluate its
investment opportunities.

1. Normally a firm’s asset is financed by some portion of debt and some portion of equity.
The return expected by creditors is known as the cost of debt, and the return expected by
shareholders is known as the cost of equity. The cost of capital is the weighted average cost
of both debt and equity to the company.

For an investment to be taken, the expected return on capital must be greater than the cost of
capital. From a firm’s perspective whatever is its cost of capital, it is the required rate of return
from an investor’s point of view but the rate is not the same due to the following factors:

1. Taxes : Interest payments on debt are tax deductible to the firm given it earns profit.
2. Floatation costs: Firms incur expenses when issuing securities (bonds or stocks) that reduce
the proceeds to the firm. Firms have to pay underwriting fees to raise the capital.
3. Asset claims: If a company goes on bankruptcy, the funds from the sale of its assets are
distributed first to bond-holders, then to preferred shareholders, and then to common
shareholders (if any funds are left).
Now the question is how can a firm raise capital or what are the composite cost of capital of
capital for a firm to buld a new factory or invest in a new project?

1
There are four major sources of capital for a firm to raise fund.
1. Common stock;
2. preferred stock;
3. Debt ( Bonds or loans);
4. Retained Earnings – ( The profit the company makes, but doesn’t give to the
shareholders in the form of dividends).

Let’s try to calculate the cost of capital by following a simple step by step process:

1. Normally a firm’s asset is financed by some portion of debt and some portion of equity.
The return expected by creditors is known as the cost of debt, and the return expected by
shareholders is known as the cost of equity. The cost of capital is the weighted average cost
of both debt and equity to the company.

All of the four types mentioned above should be incorporated into the cost of capital, with the
relative importance of a particular source being based on the percentage of the financing
provided by each source of capital/ For example, if a firm has 90% debt and 10% equity then
cost of debt will get relative importance compare to cost of equity and vice verse.

2. To compute the cost of capital it is necessary at first to compute the cost of debt which is the
average interest rate the firm pays on all of its debt. For a publicly traded company, the cost of
debt is usually the yield to maturity (YTM) of a bond minus the marginal tax rate since interest
payments or coupon payments on debt is tax deductible given the firm eanrs profit.

3. After computing the costs of debt now need to compute the cost of equity especially cost of
common stock. There are few ways of doing this, but the most popular approach is using the
capital Asset Pricing Model (CAPM):
Cost of equity = Risk-free rate + beta*(Expected market return – risk-free rate) or,
Cost of equity = Risk-free rate + beta* market risk premium.

Here the treasury bills issued by Bangladesh Bank could be used as risk-free rate,

beta represents how sensitive the firm is to market fluctuations, and the market risk premium
indicates the amount by which market return is higher than risk-free retun.

The other equation to find the cost of common stock is the dividend growth model. To use this
model to find the cost of equity first find the current market price of common stock. Then
estimate the projected dividend amount the company is expected to pay next year which is
normally based on previous dividends and the market expectations. For example, if a company
paid 8.5 taka dividend on year 2010, 9.5 taka on year 2011, and 11 taka on year 2012 then it
could be expexted an average growth rate of dividend is almost 12%. The growth rate along with
the current market price and dividend will give us the expected cost of equity.

Using the Dividend growth model, the cost of equity is:

Ke = D1/Po + g.

2
Here D1 equals to D0 + g.

4. Now to calculate the cost of preferred stock and retained earings. The cost of preferred stock is
the dividend the firms pays divided by the net price of the preferred stock which is the price of
the stock minus the floatation cost. And the cost of retained earnings is the same as cost of
common equity since retained earnings is also part of equity.

5. Calculate the proportions of debt and equity in the firm’s capital structure. Market values are
preferrable but not always available and if this is the case then use the book values for debt and
market value for equity of publicly traded firms.

6. Weight of debt = Amount of debt/(amount of debt + amount of equity)

Weight of equity = Amount of equity/(amount of debt +amount of equity).

7. Calculate the cost of capital using figures that you have worked out.
Weighted average cost of capital = cost of debt * weight of debt*(1- tax rate) + cost of
equity*weighted of equity.

The weighted cost of capital or WACC is the hurdle rate the firm should use to evaluate its
investment opportunities.

Determining the proportions of each source of capital

As a financial manager your goal is to estimate the optimum proportions of debt and equity for
your company which will maximize the shareholders wealth. If the firm decides to maintain a
pre-determined capital structure – the mix of debt, preferred stock, and the common stock –
throughout time, then the task becomes quite simple. You just figured out the proportions of
capital the company has at present. If you look at the company’s balance sheet, you can calculate
the book value of of its debt, its preferred stock, and its common stock. With these three book
values, you can calculate the proportion of debt, preferred stock, and common stock that the
company has presently. You could even look at these proportions over time to get a better idea of
the typical mix of debt, preferred stock and common stock.
But the question is whether the book values are going to tell you what you want to know? The
answer is, probably not. What you are trying to determine is the mix of capital that the company
considers appropriate which will lower the cost of capital at a given risk but will maximize the
wealth of shareholders.

Estimating the cost of each source of Capital

The cost of debt

The cost of long-term debt, Kd, is the after tax cost today of raising long-term funds through
borrowing. For convenience, you typically assume that the funds are raised through the sale of
bonds.
Net proceeds

3
Most corporate long-term debts are incurred through the sale of bonds. The cost of debt by
issuing bonds is normally computed by taking the rate on a risk free bond ( govt. Treasure bill)
whose duration matches the term structure of the corporate debt, then adding a default premium.
This default premium is usually linked with the bond rating and the default premium will rise as
the amount of debt increases since the risk rises as the amount of debt rises given all other things
being equal. Since debt expense is tax deductable, the cost of debt is computed as an after tax
cost to make it comparable with the cost of equity. It is to be noted that net earnings are after-tax
as well. The formula can be simply written as :

The cost of debt = ( risk free rate + risk premium) (1- tax rate).
The yield to maturity can be used as an approximation of the cost of debt.

It is to be noted that the firm don’t really get the entire money from the sale of the bond since
there are underwriting costs and administrative costs which is combinedly called floatation costs.
So for the new issuance of bonds this floatation costs must be deducted which is the net proceeds
for the firm.

Problem 7.1: If a firm called Vextex issues 1000 taka face value 20 years to maturity bond that
has an annual coupon rate of 15% and has 5% floatation cost and the corporate tax of 25% then
what is the firm’s cost of debt?
Solution: Here you are approximating the cost of debt since only computer can find the exact
number through trials and errors.
The before tax cost of debt, Kd, for a bond with 1000 taka par value can be approximated by
using the YTM formula:

Kd = CP + (Par value – Net proceeds)/ n

(Net proceeds + par value)/2

Where CP = annual coupon payment in BDT.

Net proceeds = par value – floatation cost.
n = number of years.

So the cost of debt for Vextex using the above formula, you find an approximation.

Kd = 150 + [1000 – (1000 – 50)]/20

[(1000-50) + 1000]/ 2

= .1564 or 15.64%.

So this is the approximate before-tax cost of debt is close to 15.64%. Since the cost of debt is tax
deductable; so after-tax cost of debt will be:

After tax cost of debt = Kd x ( 1 – tax rate )

= 15.64%(1- .25) = 11.73%.

4
Problem 7.2: Suppose Azman Enterprise can raise capital by issuing bonds with a face value of
1000 taka, a coupon rate of 5% and a 10 years to maturity at 980 per bond. If its corporate tax
rate is 30%, what is the cost of debt?
Solution: You know the approximate cost of debt before tax is:

Kd = CP + (Par value – Net proceeds)/ n

(Net proceeds + par value)/2

So, Kd = 50 + (1000 – 980)/10

(980 + 1000)/2
= 5.20%
So, after-tax cost of debt would be approximately, 5.20% (1-.30) = 3.64%.

The cost of preferred stock

Preferred stock represents a special type of ownership interest in the firm. It gives preferred
shareholders the right to receive their stated dividends before any earnings can be distributed to
common shareholders. In the event of bankrupcy, the bond holders got the first hands on the
company’s asset and then the preferred stockholders and the common stockholders are the last to
receive anything. Since preferred stock is a form of ownership, the proceeds from its sale are
expected to be held for an indefinite period of time and an annual dividend amount is stated
which is considered as cost of preferred stock.

In words, Cost of preferred stock = Kp = Dividend per share

Price per share – Floatation cost
Or, the cost of preferred stock, Kp = Dp/Np.

Here Kp is the cost of preferred stock, Dp is the stated dividend amount and Np is the net proceeds
which is money received from the sale of preferred stock minus floatation cost.

Problem 7.3: Vextex is thinking of issuing a 15% stated dividend preferred stock that is expected
to sell for 65 taka per share and has a 5 taka floatation cost. What is the cost of Vextex’s
preferred stock?
Solution:
The cost of preferred stock Kp = Dp/Np.
Here for Vextex’s cost of preferred stock, Kp = 9.75/(65-5) = 16.25%.
Here we can see the cost of preferred stock is much higher than the cost of debt since the cost of
debt was tax deductable and the bond holders have got the first claim on the asset if the company
goes into bankrupcy.
Problem 7.4: Suppose ABC Company is advised that if it issues preferred stock with a fixed
dividend of 4 taka a share, it will be able to sell these share at 30 taka per share minus 5%
floatation cost. What is the cost of preferred stock to ABC Company?
Solution: Kp = 4/ (30 – 1.5) = 14.35%. [ 5% of 30 taka is 1.5 taka]
Calculating the cost of common equity

5
The cost of equity is more challenging to calculate as equity does not pay a set return to its
investors which varies year to year. There are two forms of common equity financing: 1) new
issues of common stock and 2) retained earnings.
If a firm issues new common stock then it is financing externally but if it uses its own retain
earning then it is financing internally both of which have cost.
How does internally generated capital have a cost? As a company generates profits, some portion
is used to pay off creditors (i.e. bank loan or bond-holders) and preferred shareholders. The
remaining profit could be shared with the common shareholders entirely or keep it as retain
earning for future capital budgeting or distribute a portion to common shareholders and keep the
rest as retained earnings. Now the shareholders will require their company to use retained
earnings to generate a return that is at least as large as the return they could have generated for
themselves.

So you can see retained earnings are not free source of capital. It is the opportunity cost to
common shareholders which they could have earned on these funds for the same level of risk.
The only difference between the cost of retained earnings and the cost of common stock (new
issued) is the cost of issuing which is called the floatation costs. Since retained earnings are
internally raised it doesn’t require any floatation costs like the one it requires for the issuance of
new common stock.
The cost of issuing common stock is difficult to estimate because of the nature of the cash flow
streams to common shareholders. Common shareholders amount of dividend is hard to predict
(not fixed like the preferred stockholders) and also the changes in the price of the common shares
fluctuate every day which is influenced by not only company’s performance but also the
investors’ expectations which could be quite irrational at times. Besides some firms issues right
shares for the common shareholders which helps the common shareholders.
There are two methods commonly used to estimate the cost of common stock: the Dividend
Valuation Model and the Capital Asset Pricing Model. Each model relies on different
assumptions which produce different estimates of the cost of common equity.
Cost of common equity using the dividend valuation model
The dividend valuation model is also known as the constant-growth model or the Gordon model.
It states that the price of a share of stock is the present value of all its future cash dividends,
where the future dividends are discounted at the required rate of return on equity. But if the
dividends are constant like preferred stock then the cost of equity is same like cost of preferred
stock given both has the same floatation cost. But in reality, dividends usually do not remain
constant. It is widely expected that it will grow in near future and an expected growth rate is
calculated.
So using the dividend growth model, you find
P0 = D1 / (Ke – g).
Where D1 is the next period’s dividends, g is the growth rate of dividends per period, and P0 is the
current stock price per share and K e is the cost of common stock. Rearranging the equation you
get the cost of equity.
6
Ke = D1 + g
P0
So you can see cost of common stock = Dividend yield + Growth rate of dividends.

Problem 7.5: If a firm is expected to pay 2 taka dividend in the next period and it is expected to
grow at 3 percent per period and the share price is 28.57 taka then what is the required rate of
return on common stock using dividend growth model?
Solution:
Ke = D1 + g
P0
Ke = 2/28.57 + 0.03 = 0.1 or 10% is the cost of equity.
Problem 7.6: ABC company paid 2 taka cash dividend last year and is expected to increase the
dividend by 5 percent next year whereas the current market price of ABC’s common stock is 25
taka. What is the cost of equity on ABC using dividend growth model?
Solution:
Given: P0 = 25 taka; D0 = 2 taka; and g = 5%
Ke = D0(1+g) + g
P0
Ke = 2(1+0.05) + 0.05
25
= 0.134 or 13.4%.
Cost of common equity using the capital asset pricing model (CAPM)
Most businesses use the Capital Asset Pricing Model (CAPM) to estimate the cost of equity.
Here are the steps to estimate the cost of common equity:
 Estimate the economy's risk free rate. The risk-free rate is usually the rate of return on
government Treasury bills.
 Estimate the stock market's current rate of return which could be the average return over the
past 10 years.
 Estimate the risk of the stock of the company as compared to the market. This measure is
called beta.
The beta (risk) of the market is specified as 1.0. If the company's risk is greater than the market,
its beta is greater than 1.0 and vice versa. You can use historical stock price information to
measure beta. You can adjust the historical beta for fundamental factors specific to the company.
Often, it is a judgment call on the part of company management.

Plugging the variables into the CAPM equation, you get:

Cost of Equity = Risk-free rate + Beta (Market Rate of Return - Risk-Free Rate).
Ke = Krf + β (Km - Krf).

7
Basically, the cost of common equity estimated using the CAPM is the sum of investor’s
compensation for the time value of money and the investor’s compensation for the market risk of
the stock:
Cost of common equity (using CAPM) = compensation for + Compensation for
time value of money market risk.
Problem 7.7: If the risk-free rate on government Treasury bond is 12% and the current market
expected rate of return is 15% and the beta of a company's stock is estimated to be 1.5, then what
should be the company's cost of equity?
Solution: 12% + 1.5(15% - 12%) = 16.5%.
Problem 7.8: Suppose the risk free rate is 14 percent and the cost of equity is 21.2% and the beta
of this firm is 1.8. What was the expected return from the market?

Solution: You know already, Ke = Krf + β (Km - Krf).

Or, 21.2% = 14% + 1.8(Km - 14%)
Or, 1.8Km = 21.2% - 14% + 25.2%
So, Km = 18%.

Calculate the Weighted Average Cost of Capital

The cost of capital is the average of the cost of each source, weighted by its proportion of the
total capital it represents. Hence it is term weighted average cost of capital or WACC. After you
have calculated the cost of capital for all the sources of debt and equity that you use, now it is
time for you to calculate the weighted average cost of capital for your company. You weight the
percentage of the capital structure that each source of debt and equity capital is by the cost of the
source of capital.

The total capital for a firm is the value of its equity plus the amount of total debt. Notice that the
equity in the debt to equity ratio is the market value of all equity, not the shareholders’ equity on
the balance sheet.

A company’s capital structure or total capitalization is comprised of two main components: debt
and equity (as represented by D + E). The rates—rd (return on debt) and re (return on equity)—
represent the company’s market cost of debt and equity, respectively. As its name implies, the
ensuing weighted average cost of capital is simply a weighted average of the company’s cost of
debt (tax-effected) and cost of equity based on an assumed or “target” capital structure.
A step by step process for calculating WACC is shown below:
Step 1: Determine target capital structure.
Step 2: Estimate cost of debt (kd) and marginal tax rate (%).
Step 3: Estimate cost of preferred stock (kp) if any is used before or wants to issue.
Step 4: Estimate cost of equity (ke).
Step 5: Calculate WACC using the following equation.

8
 Debt
WACC= ( 1−taxrate ) k d +¿
Assets

Here Debt/Assets are the market value of debt over market value of assets.

Equity/Assets are the market value of debt over market value of assets.

One of the implications of WACC is that any project that has the same risk as the firm, must
have an IRR that is equal to or greater than the weighted average of security returns. If the cash
flows of the project discounted using WACC yield a negative NPV, the project should not be
undertaken.

Example: WACC

For Vertex, assume the following weights: wd = 40%, wps = 5% and wce = 55%.
Compute Vertex's weighted average cost of capital using the cost of debt 7%, cost of preferred
stock 2.1%, and cost of equity 12% where the corporate tax is 40%. For the purposes of this
example, assume new equity comes from retained earnings and the discounted cash flow
approach is used to derive kce.

Answer:
WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)

WACC = 0.084, or 8.4%.

Taking the example further, suppose new equity needs to come from newly issued common
stock and a floatation cost must be incorporated which raises the cost of equity from 12% to
12.3%; the WACC would then be calculated using a kc of 12.3%. Thus the WACC would be as
follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086 or 8.6%

Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost of the last monetary unit (taka) of capital raised,
essentially the cost of another unit of capital raised. As more capital is raised, the marginal cost
of capital rises.

With the weights and costs given in our previous example, you computed Vertex's weighted
average cost of capital as 8.4%.

You originally determined the WACC for Vertex to be 8.4%. Vertex's cost of capital will remain

9
unchanged as new debt, preferred stock and retained earnings are issued until the company's
retained earnings are depleted.

Example: Marginal Cost of Capital

Once retained earnings are depleted, Vertex decides to access the capital markets to raise new
equity. As in the previous example for Vertex, assume the company's stock is selling for Tk. 40,
its expected ROE is 10%, next year's dividend is Tk. 2.00 and the company expects to pay out
30% of its earnings. Additionally, assume the company has a flotation cost of 5%. Vertex's cost
of new equity (kc) is thus 12.3%, as calculated below:

kc = 2 / (40(1-0.05) + 0.07 = 0.123, or 12.3%

Due to the floatation cost, the cost of equity went up from 12% to 12.3% which has raised the
WACC from 8.4% to 8.6% which is the marginal cost of capital since it will be the new cost of
capital when the firm raises new capital.

The WACC has been stepped up from 8.4% to 8.6% given Vertex's need to raise new equity.

Problem 7.9: ABC Bank has the following financing outstanding:

Debt: 50,000 bonds with an 8% coupon rate and a quoted price of 119.8% of par value of 1000
taka; the bonds have 15 years to maturity.
Preferred Stock: 120,000 shares of 6.5% preferred with a current price of 112 taka, and a par
value of 100 taka.
Common stock: 2,000,000 shares of common stock at a 10 taka par value, the current price is 65
taka, and the beta of the stock is 1.1.
Market: The corporate tax rate is 40%, the market risk premium is 9%, and the risk-free rate is
4%.
What is the WACC for the company?

Solution:
You will begin by finding the market value (MV) of each type of financing. You will use D 1 to
represent the coupon bond, P for preferred and E for common stock. So, the market value of the
firm’s financing is:

MVD1 = 50,000(1,000)(1.1980) = 59,900,000 taka

MVP = 120,000(112) = 13,440,000 taka
MVE = 2,000,000(65) = 130,000,000 taka.

And the total market value of the firm is:

V = 59,900,000 + 13,440,000 + 130,000,000 = 203,340,000 taka.

Now, you can find the cost of equity using the CAPM. The cost of equity is:
= .04 + 1.10(.09) = .1390 or 13.90%

10
The cost of debt is the YTM of the bonds, so:
Approximate YTM = 80 + (1000 – 1198)/15
(1000+1198)/2
= 6.07%.

And the after-tax cost of debt is:

kd = (1 – .40)(.0607) = .0364 or 3.64%
To find the required return on preferred stock, we can use the preferred stock pricing equation,
which is the level perpetuity equation, so the required return on the company’s preferred stock is:
kp = D1 / P0
kp = 6.50 taka / 112 taka = .0580 or 5.80%.

So plugging the numbers in the WACC equation you get:

Debt
WACC= ( 1−taxrate ) k d +¿
Assets
59,900,000 13,440,000 130,000,000
WACC= ( 1−0.40 ) (.0607)+ ( 0.058 ) + ( 0.139 )
203,340,000 203,340,000 203,340,000

So, WACC = 10.34%

You can see the cost of debt before corporate tax is 6.07% and 3.64% after tax. You must not
deduct it twice! Also notice that the required return in the preferred stock is lower than the
required on the bonds. This result is not consistent with the risk levels of the two instruments, but
is a common occurrence. There is a practical reason for this: Assume Company A owns stock in
Company B. The tax code allows Company A to exclude at least 70 percent of the dividends
received from Company B, meaning Company A does not pay taxes on this amount. In practice,
much of the outstanding preferred stock is owned by other companies, who are willing to take
the lower return since it is effectively tax exempt.
Problem 7.10: XYZ Corporation has 9 million shares of common stock outstanding and 120,000
8.5% semiannual bonds outstanding, par value Tk.1,000 each. The common stock currently sells
for 34 taka per share and has a beta of 1.2, and the bonds have 15 years to maturity and sell for
93% of par. The market risk premium is 10%, T-bills are yielding 5%, and XYZ’s tax rate is
35%.
a. What is the firm’s market value capital structure?
b. If XYZ is evaluating a new investment project that has the same risk as the firm’s typical
project, what rate should the firm use to discount the project’s cash flows?
Solution:
a. You will begin by finding the market value of each type of financing. You find:
MVD = 120,000(Tk.1,000)(0.93) = Tk.111,600,000
MVE = 9,000,000(Tk.34) = Tk.306,000,000
And the total market value of the firm is:
V = Tk.111,600,000 + Tk.306,000,000 = Tk.417,600,000
So, the market value weights of the company’s financing is:
D/V = 111,600,000/417,600,000 = .2672

11
E/V = 306,000,000/417,600,000 = .7328
b. For projects equally as risky as the firm itself, the WACC should be used as the discount rate.
First we can find the cost of equity using the CAPM. The cost of equity is:
ke= .05 + 1.20(.10) = .1700 or 17.00%

The cost of debt is the YTM of the bonds, so:

Approximate YTM = 42.5 + (1000 – 930)/15

(1000 + 930)/2

= 4.8%.

YTM = 4.8% × 2 = 9.6%. if you use financial calculator the exact YTM will be 9.38%
And the after-tax cost of debt is:
Ke = (1 – .35)(.0938) = .0610 or 6.10%

Now we can calculate the WACC as:

WACC = .1700(.7328) + .0610 (.2672) = .1409 or 14.09%

Problem 7.11: The following are the information of a company:

Type of capital Book value Market value (Tk) Specific cost (%)
(Tk)
Debt 300000 380000 7%

Preference share 200000 220000 8%

Equity share 600000 600000 14%

Retained earnings 200000 500000 11.2%

      1300000        1700000

 Determine the weighted average cost of capital using (A) Book value weights and, (B)
Market value weights. How are they different? Can you think of a situation where the
weighted average cost of capital would be the same using either of the weights?

Solution: (A)    Weighted Average Cost of Capital (WACC)

Type of capital Book Capital Specific Weighted
value (Tk) ratio cost Average
(Tk)
(1) (2) (3) = (2)/Sum2 (4) (5) =(3)*(4)
Debt 300000 0.23 0.07 0.0161

Preference share

12
 Equity share 200000 0.15 0.08 0.0120

Retained earnings 600000 0.46 0.14 0.0644

200000 0.16 0.112 0.0179

Sum: 1300000 1 SWA = 0.1104

So the book value weight is WACC = 0.1104 = 11.04%  

            (B)          Weighted Average Cost of Capital (WACC)

Type of capital Market Capital Specific Weighted

value ratio cost Average

(Tk) (Tk)
(1) (2) (3) = S(2) (4) (5) =(3) ´ (4)
(2)
Debt 380000 0.22 0.07 0.0154

Preference share 220000 0.13 0.08 0.0104

Equity share 600000 0.35 0.14 0.0490

Retained earnings 500000 0.30 0.112 0.0336

1700000 SWA = 0.1084
So the market value weight is WACC = 0.1084 = 10.84%.

Comment: When the book value and the market value have the same totals, then the weighted
average cost of capital would be the same using either of the weights.

There is a cost differential between debt and equity. If debt is less expensive than debt, why don't
firms increase their leverage and reduce WACC? If the proportion of debt increases, the leverage
increases as well as the risk of the firm, because the firm has to dedicate an increasing proportion
of its cash flows to the repayment of debt related obligations. This curtails the firm's growth
opportunities and makes the profitability of the firm more sensitive to financial and economic
downturns. As a result, it would be deceptive to assume that the required rate of return on the
debt and equity will remain the same. Remember that the relationship between risk and return is
direct: increasing risk leads to increased returns; thus, owners of the firm's debt and equity will
require higher returns.

WACC is the return the firm expects its average risk project to earn in order to provide security
holders with an adequate return. This means that cash flows generated by a project that is more
risky than the average, should use an appropriately upwardly adjusted discount rate.

13
Conclusion: Determining the cost of capital seems quite straight-forward: find the cost of each
source of capital and weigh it by the proportion it will represent in the firm’s new capital. But it
is not that simple. Here are some of the complexities that arise when you try to calculate cost of
capital.
 How do you know what would be the floatation cost when you intend to issue new bond.
You may get a quote but until you raise it the exact cost won’t be possible for you to
calculate.
 How do you know given a fixed dividend what would be the price of a preferred stock?
 When you calculated the cost of common equity you used either CAPM or DVM but you
also know the problems associated with both model and also those variables like dividend
growth, risk free rate, market return or historical beta are not constant.

So estimating the cost of capital requires a good deal of judgment. It requires an understanding
of the current risk and return associated with the firm and its securities as well as the market and
the aggregate economy.

Exercise 7.1: The following figures are taken from the current balance sheet of XYZ Inc.

Capital Tk.8,00,000
Share Premium 2,00,000
Reserves 6,00,00
Shareholder’s funds 16,00,000
12% irredeemable debentures 4,00,00

An annual ordinary dividend of Tk.2 per share has just been paid. In the past, ordinary dividends
have grown at a rate of 10 per cent per annum and this rate of growth is expected to continue.
Annual interest has recently been paid on the debentures. The ordinary shares are currently
quoted at Tk.27.5 and the debentures at 80 per cent. Ignore taxation.

You are required to estimate the weighted average cost of capital (based on marker values) for
XYZ Inc.

Solution

In order to calculate the WACC, the specific cost of equity capital and debt capital are to be
calculated as follows:
Ke = 2( 1.1)/27.50 + 0.10 = 18%.

The market value of equity is 80,000 x Tk.27.50 = Tk.22,00,000

Kd = 12/80 = 15%

The market value of debt is 4,00,000 x .80 = Tk.3,20,000.

The market value of the firm will be Tk.22,00,000 + Tk.3,20,000 = 25.20,000 taka.
Now, the WACC is

14
(22,00,000 / 25,20,000) x .18 + (3,20,000/25,20,000) x .15 = .176 = 17.6%

Note: In this case, the dividend of Tk.2 has just been paid. So, D0 = Tk.2 and the D1, i.e. dividend
expected after one year from now will be D0 x (1 + g) = Tk.2 x 1.10.

Exercise 7.2:
Zebe Industries, a maker of telecommunications equipment, has 2 million shares of common
stock outstanding, 1 million shares of preferred stock outstanding, and 10 thousand bonds. If the
common shares are selling for Tk. 27 per share, the preferred share are selling for Tk.14.50 per
share, and the 1000 taka par value bonds are selling for 98 percent of par, what would be the
weight used for equity in the computation of Zebe’s WACC?

Solution: The weight should be used for equity is:

We = E/(E+D+P) = (27 x 2m )/(27 x 2m +14.50 x 1m + 10,000 x 0.98 x 1000) = 68.97%.

Exercise 7.3: Suppose that Tapan Inc.’s capital structure features 65 percent equity, 35 percent
debt, and that its before-tax cost of debt is 8 percent, while its cost of equity is 13 percent. If the
appropriate weighted average tax rate is 34 percent, what will be Tapan’s WACC?

E P D
WACC  iE  iP  iD   1  TC 
EPD EPD EPD
 .65  13%  0  0%  .35  8%   1  .34 
 10.298%

SUMMARY:

The cost of capital is the marginal or additional cost of raising additional funds. This cost is very
important in your investment decision making because you ultimately want to compare the cost
of funds with the benefits from investing these funds. For example, the cost of capital is quite
low in Japan (around 2%-6%) but there is not much demand for capital by the Japanese
Entrepreneurs since this capital has to be invested and the return must exceed the cost of capital.
The cost of capital is determined in three steps: 1) determine what proportions of each source of
capital you intend to use; 2) calculate the cost of each source of capital, and 3) put the cost and
the proportions together to determine the weighted average cost of capital.
The cost of debt is the yield determines by the creditors which is usually YTM of a bond, the
cost of common stock is more difficult to estimate but the cost of preferred is the easiest which is
the yield demanded by the preferred stock holders.
The proportion of each source of capital that you use in calculating the cost of capital is based on
what proportions you expect the company to raise new capital. If the company already has a
capital structure – a mix of debt and equity it feels appropriate – the same proportion of each
source of capital, in market terms, is a good estimate of the proportions of new capital.

15
The actual estimation of the cost of capital for a firm requires a bit of educated guesswork, and
lots of reasonable assumptions. What you can do as a financial manager is you can arrive at a
good enough estimate of the cost of capital.

Case Study 1: Equity or debt: which one is cheaper?

Put yourself in the shoes of the CFO of a company. One major aspect you will be confronted
with in your job will relate to the financing of your company's assets. Just like a plant needs
water to grow, businesses need capital in order to expand. For this you have two basic choices,
go to a bank and ask for a loan or sell a stake in your company to raise capital. Basically issue
either debt or equity.

As a CFO, you would be ideally looking for the cheapest source of finance. So as a general rule,
which source is cheaper, debt or equity?

Well with all the IPOs which are coming to the market gaining 300% to 500% in the trading
days, you must be thinking that equity is the cheaper source of finance. After all, successful
entrepreneurs are just selling a small portion of their business. And with markets currently at
lofty valuations, it may be a lot easier to get a handsome bargain. Some businesses even take on
additional equity to pay off their debt lenders. So equity seems cheaper, right? ………Wrong!

Debt is actually the cheaper source of finance for a couple of reasons.

Tax benefit: The firm gets an income tax benefit on the interest component that is paid to the
lender. Dividends to equity holders are not tax deductable.

Limited obligation to lenders: In the event of a firm going bankrupt, equity holders lose almost
everything. But, debt holders have the first claim on company assets (collateral), increasing their
security. So since debt has limited risk, it is usually cheaper. Equity holders are taking on more
risk, hence they need to be compensated for it with higher returns.

However, taking on debt financing, though cheaper is not without risks for the firm taking on the
debt (borrower). Or taking on debt may not be suitable in certain situations. There is limited risk
for the lender, but high risk for the borrower. This is because the debt needs to be serviced i.e.
principal and interest repayments need to be made, irrespective of whether the firm is making a
profit or a loss or general economic conditions. Firms with large debt balances during the
economic crisis felt tremendous pressure.

Taking on debt can be beneficial till a certain point. But when the company becomes over-
leveraged, the cost of raising additional debt becomes more and more expensive. This is because
the earlier lenders would have laid the first claim on the company's assets. The subsequent
lenders will thus charge more interest as the lending becomes riskier. Credit ratings also
deteriorate as more and more debt capital is raised.

Now you know that debt is usually a cheaper source of finance than equity, but not always the
case. Equity owners benefit from taking higher risks due to their ownership claim which means

16
if the firm does very well then after paying the credit holders like bond and preferred holders
they get to keep all the profits except if the firm intends to retain some earnings for future capital
budgeting purposes. So next time if you see debt on the balance sheet of a company you are
looking at investing in, don't be too alarmed. If the quantum of debt is not too high and it is taken
at cheap rates then it is a good, cheap alternative. The company's return on equity can even be
enhanced through leverage.

However, this does not mean that taking on debt is suitable for all companies. And risks of over-
leveraging are always there. Too much of a good thing is usually bad.

Question 1: Which source of capital is the cheapest and why?

Question 2: Why would a firm uses equity financing since it is the highest cost of capital?
Question 3: How does the equity owners are compensated for adding higher risk?
Question 4: Leveraging is a double edged sword- can you explain the pros and cons of
leveraging?

Integrated Case Study on the cost of capital:

Aamba Technologies Inc.

Aamba Technologies is considering a major expansion program that has been proposed by the
company’s information technology group. Before proceeding with the expansion, the company
must estimate its cost of capital.

Assume that you are an assistant to Areef Khan, the Chief Financial Officer. Your first task is to
estimate Aamba’s cost of capital. Mr. Khan has provided you with the following data, which he
believes may be relevant to your task:
1. The firm’s tax rate is 40%.
2. The current price of Aamba’s 12% coupon, semiannual payment, non-callable bonds with 15
years remaining to maturity is Tk. 1,153.72.
Aamba does not use short-term interest-bearing debt on a permanent basis. New bonds would be
privately placed with no flotation cost.
3. The current price of the firm’s 10%, Tk. 100 par value, quarterly dividend, perpetual preferred
stock is Tk. 111.10.
4. Aamba’s common stock is currently selling for 50 taka per share. Its last dividend (D 0) was
Tk. 4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future.
Aamba’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be
6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%.
5. Aamba’s target capital structure is 30% debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Mr. Khan has asked you to answer the following questions.

A. (1) What sources of capital should be included when you estimate Aamba’s WACC?
Answer: The WACC is used primarily for making long-term capital investment decisions, i.e.,
for capital budgeting. Thus, the WACC should include the types of capital used to pay for long-
term assets, and this is typically long-term debt, preferred stock (if used), and common stock.
Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as

17
accounts payable and accrued liabilities and (2) short-term interest-bearing debt, such as notes
payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to
finance working capital needs, then the WACC should include a short-term debt component.
Noninterest-bearing debt is generally not included in the cost of capital estimate because these
funds are netted out when determining investment needs, that is, net operating rather than gross
operating working capital is included in capital expenditures.

A. (2) Should the component costs be figured on a before-tax or an after-tax basis?

Answer: Stockholders are concerned primarily with those corporate cash flows that are available
for their use, namely, those cash flows available to pay dividends or for reinvestment.
Since dividends are paid from and reinvestment is made with after-tax takas, all cash flow and
rate of return calculations should be done on an after-tax basis.

A. (3) Should the costs be historical (embedded) costs or new (marginal) costs?
Answer: In financial management, the cost of capital is used primarily to make decisions that
involve raising new capital. Thus, the relevant component costs are today’s marginal costs rather
than historical costs.

B. What is the market interest rate on Aamba’s debt and its component cost of debt?
Answer: Aamba’s 12% bond with 15 years to maturity is currently selling for Tk. 1,153.72.
Thus, its yield to maturity is 10%:

Approximate YTM = Coupon Payment + Face Value – Market value

No. of years to maturity
(Face value + Market value)/2

= 120 + (1000 – 1153.72)/15

(1000+1153.72)/2

= 10.19%

If you find it using computer programme the exact YTM will be 10% which is the cost of debt.

Since interest is tax deductible, National Board of Revenue (NBR), in effect, pays part of the
cost, and Aamba’s relevant component cost of debt is the after-tax cost:
rd(1 – T) = 10.0%(1 – 0.40) = 10.0%(0.60) = 6.0%.

C. Aamba’s preferred stock is riskier to investors than its debt, yet the preferred’s yield to
investors is lower than the yield to maturity on the debt. Does this suggest that you have made a
mistake?
Answer: Corporate investors own most preferred stock, because 70% of preferred dividends
received by corporations are nontaxable. Therefore, preferred often has a lower before-tax yield
than the before-tax yield on debt issued by the same company. Note, though, that the after-tax
yield to a corporate investor and the after-tax cost to the issuer are higher on preferred stock than
on debt.

18
D. (1) Why is there a cost associated with retained earnings?
Answer: Aamba’s earnings can either be retained and reinvested in the business or paid out as
dividends. If earnings are retained, Aamba’s shareholders forgo the opportunity to receive cash
and to reinvest it in stocks, bonds, real estate, and the like. Thus, it should earn on its retained
earnings at least as much as its stockholders themselves could earn on alternative investments of
equivalent risk. Further, the company’s stockholders could invest in Aamba’s own common
stock, where they could expect to earn re. We conclude that retained earnings have an
opportunity cost that is equal to re, the rate of return investors expect on the firm’s common
stock.

D. (2) What is Aamba’s estimated cost of common equity using the CAPM approach?
Answer: The CAPM estimate for Coleman’s cost of common equity is 14.2%:
re = rRF + (rM – rRF).b
= 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%.

E. What is the estimated cost of common equity using the DCF approach?
Answer: Since Coleman is a constant growth stock, the constant growth model can be used:

D1
^
ℜ= +g
p0

re = 4.19(1+0.05) + 0.05
50.00
= 0.088 + 0.05 = 8.8% + 5.0% = 13.8%.

F. What is the bond-yield-plus-risk-premium estimate for Aamba’s cost of common equity?

Answer: The bond-yield-plus-risk-premium estimate is 14%:
re = Bond yield + Risk premium = 10.0% + 4.0% = 14.0%.
Note that the risk premium required in this method is difficult to estimate, so this approach only
provides a ballpark estimate of re. It is useful, though, as a check on the DCF and CAPM
estimates, which can, under certain circumstances, produce unreasonable estimates.

G. What is your final estimate for r e?

Answer: The following table summarizes the re estimates:
Method Estimate
CAPM 14.2%
DCF 13.8
rd + r p 14.0
Average 14.0%

At this point, considerable judgment is required. If a method is deemed to be inferior due to the
“quality” of its inputs, then it might be given little weight or even disregarded. In the above

19
example, though, the three methods produced relatively close results, so it has decided to use the
average, 14%, as an estimate for Aamba’s cost of common equity.

H. Explain in words why new common stock has a higher cost than retained earnings.
Answer: The company is raising money in order to make an investment. The money has a cost,
and this cost is based primarily on the investors’ required rate of return, considering risk and
alternative investment opportunities. So, the new investment must provide a return at least equal
to the investors’ opportunity cost.
If the company raises capital by selling stock, the company doesn’t receive all of the money that
investors contribute. For example, if investors put up Tk. 100,000, and if they expect a 15%
return on that Tk. 100,000, then Tk. 15,000 of profits must be generated.
But if flotation costs are 20% (Tk. 20,000), then the company will receive only Tk. 80,000 of the
Tk. 100,000 investors contribute. That Tk. 80,000 must then produce a Tk. 15,000 profit, or a
15/80 = 18.75% rate of return versus a 15% return on equity raised as retained earnings.

I. (1) What are two approaches that can be used to adjust for flotation costs?
Answer: The first approach is to include the flotation costs as part of the project’s up-front cost.
This reduces the project’s estimated return.
The second approach is to adjust the cost of capital to include flotation costs. This is most
commonly done by incorporating flotation costs in the DCF model.

I. (2) Aamba estimates that if it issues new common stock, the flotation cost will be 15%. Aamba
incorporates the flotation costs into the DCF approach. What is the estimated cost of newly
issued common stock, considering the flotation cost?
Answer:
D1 D 0 ( 1+ g )
^
ℜ= + g= +g
p 0−F p 0−F

re = 4.19 (1+0.5) + 0.05

50(1-0.15)
re = 10.35% + 5.0% = 15.35%.
J. What is Aamba’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
Answer: Aamba’s WACC is 11.1%.

Capital Structure Component

Weights x Costs = Product

0.3 6% = 1.8%
0.1 9% = 0.9%
0.6 14% = 8.4%
1.0 WACC = 11.1%
WACC = Wd.rd(1 – T) + Wp.rp + We.re
= 0.3(10%)(1 – 0.4) + 0.1(9%) + 0.6(14%)

20
= 1.8% + 0.9% + 8.4% = 11.1%.

K. What factors influence Aamba’s composite WACC?

Answer: There are factors that the firm cannot control and those that they can control that
influence WACC.
Factors the firm cannot control:
 Interest rates;
 Tax rates.
Factors the firm can control:
 Capital structure policy;
 Dividend policy;
 Investment policy.

L. Should the company use the composite WACC as the hurdle rate for each of its projects?
Answer: No. The composite WACC reflects the risk of an average project undertaken by the
firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average
risk. Different projects have different risks. The project’s WACC should be adjusted to reflect
the project’s risk.

State whether each of the following statements is True (T) or False (F)

1. The cost of capital is the required rate of return for the capital providers. True
2. Different sources of funds have the same specific cost of capital related to that source only.
3. Cost of capital does not comprise any risk premium.
4. Risk free interest rate and cost of capital are same things.
5. Different sources have same cost of capital.
6. Tax liability of the firm is relevant for cost of capital of all the sources of funds. True
7. Cost of debt and Cost of Preferred share capital, both require tax adjustment.
8. WACC is the overall cost of capital of the firm. True
9. Cost of Preferred share capital is determined by the rate of fixed dividend and price of the
preferred stock. True
10. Cost of Equity share capital depends upon the market price of the share. True
11. Cost of existing share capital and fresh issue of capital are same.
12. WACC is always calculated with reference to book value of different sources of funds.
13. Book Value & Market Value weights are always different.
14. Retained earnings have no market value, so these are not included in WACC (based on
market value)

21
Answers: 1. T, 2. F, 3. F, 4. F, 5. F, 6. T, 7. F, 8. T, 9. T, 10. T, 11. F, 12. F, 13. F, 14. F

MULTIPLE CHOICE QUESTIONS:

1. Cost of Capital refers to:

A) Flotation Cost (B) Dividend C) Required Rate of Return D) None of the above

2. Which of the following capital has the highest cost?

A) Equity B) Bond C) Preferred D) Retain earnings

3. Which of the following cost of capital require tax adjustment?

A) Equity B) Bond C) Preferred D) Retain earnings

4. Which of the following capital has the lowest cost?

A) Equity B) Bond C) Preferred D) Retain earnings

5. Marginal cost of capital is the cost of:

A) additional funds C) additional projects
B) additional interest D) additional equity

6. If a firm is not leveraged at all then the cost of capital will be

A) The cost of debt C) The cost of preferred
B) The cost of equity D) None of the above

7. Advantage of Debt financing is:

A) Interest is tax-deductible C) It reduces WACC
C) Does not dilute owners control D) All of the above

8. One assumption underlying the use of the cost of capital to analyze capital projects is that:
A) current costs will remain the same
B) capital structure will vary with the type of financing
C) different risk projects are required to diversify the firm
D) the analyzed projects are of comparable risk to existing projects

9. The cost of debt is measured by:

A) the yield to maturity on the firm’s bonds
B) the coupon rate on the firm’s bonds
C) the weighted average cost of capital
D) the marginal cost of capital

10. The after-tax cost of debt is expressed:

A) Kd = YTM/k(1-Tax)
B) Kd = YTM(1-Tax)
C) Kd = (1-t)/YTM
D) Kd = YTM

22
11. The cost of new preferred stock is determined: by the --------- because they are similar.
A) cost of common stock
B) cost of debt
C) Dp/Kp = P- F
D) Dp/Kp = Pp.
12. The beta coefficient measures:
A) the return relative to the risk-free rate
B) the return relative to the market return
C) the historical volatility relative to the market’s volatility
D) the required return on a financial asset.

13. The cost of retained earnings is equal to:

A) the return on new common stock
B) the return on preferred stock
C) the return on existing common stock
D) It does not have a cost.

14. The least expensive form of financing for the firm is:
A) existing common stock
B) preferred stock
C) debt
D) new common stock.

15. In determining the appropriate capital mix, the starting point for the firm is:
A) the cost of common equity
B) the optimum capital structure
C) the present capital structure
D) the after-tax cost of debt.

16. The cost of capital is best calculated with:

A) market value weightings
B) book value weightings
C) Modigliani and Miller weightings
D) It doesn’t matter.

17. Financial capital:

A) appears under liabilities and equity on the corporate income statement
B) and the optimum capital structure are the same
C) consists of common stock, preferred stock and retained earnings only
D) consists of stocks, bonds and retained earnings.

18. Regardless of the type of asset being acquired, the appropriate discount rate is:
A) the after-tax cost of debt
B) the required rate of return
C) the weighted average cost of capital
D) the cost of equity capital

23
19. As more and more funds are required by the firm, the cost of each component of the capital
structure may increase. These incremental changes are most correctly referred to as:
A) the weighted average cost of capital
B) the marginal cost of capital
C) the cost of capital
D) the incremental cost of capital

20. A firm’s tax rate is 34%. Its pre-tax cost of debt is 8%; the firm’s debt to equity ratio is 3; the
risk free rate is 3%; the beta of the firm’s common stock is 1.5; the market risk premium is
9%. What is the firm’s weighted average cost of capital?

A) 8.09% B) 9.28% C) 7.8% D) None of the above

Answers: 1. C, 2. A, 3. B, 4. B, 5. A, 6. B, 7. D, 8. D, 9. A, 10. B, 11. C, 12. C, 13. C, 14. C, 15.

C, 16. A, 17. D, 18. C, 19. B, 20. A

SHORT QUESTIONS:

1. What are the major sources of capital for a firm? Page 1

2. What factors affect the composite cost of capital? Page 20
3. What factors that affect the cost of capital are beyond the firm’s control? Page 20
4. What policies under the firm’s control are likely to affect its cost of capital?
5. What is the marginal cost of capital? Page 9
6. Why is the after-tax cost of debt rather than the before tax cost used to calculate the weighted
average cost of capital?
7. What three approaches are used to estimate the cost of equity? Page 7
8. Why is debt a cheaper form of finance than equity? Page 15
9. Why should a financial manager incorporate an opportunity cost to retain earnings?
10. Is short-term debt included in the capital structure used to calculate WACC? Why or why
not?
11. ABC plans to issue some 50 taka par preferred stock with an 15 percent dividend. The stock
is selling on the market for 42 taka, but it must pay floatation costs of 6 percent of the market
price. What is ABC’s cost of preferred stock?
12. Vertex can issue perpetual preferred stock at a price of 35 taka a share. The firm is expected
to pay 4 taka a share. What is Vertex’s cost of preferred stock?

BROAD QUESTIONS:

24
1. Assume that there is an increase in the risk-free rate. What impact would this increase have
on the cost of debt? What impact would this have on the cost of equity?
2. Identify some problem areas in cost of capital analysis. Do these problems invalidate the cost
of capital procedures?
3. ABC corporation has a target capital structure of 40 percent debt and 60 percent equity. The
yield to maturity on the firm’s outstanding bonds in 9 percent and the company’s tax rate is
35 percent. ABC’s finance manager has calculated the firm’s WACC at 12.4 percent. What is
the company’s cost of common equity? Ans: 16.76%
4. ABC company’s currently outstanding 10 percent copon bonds have a yield to maturity of 12
percent. ABC believes it could issue at par new bonds that would provide a similar yield to
maturity. If its marginal tax rate is 35 percent, what is ABC’s after-tax cost of debt?
5. ABC plans to issue some 50 taka par preferred stock with an 15 percent dividend. The stock
is selling on the market for 42 taka, but it must pay floatation costs of 6 percent of the market
price. What is ABC’s cost of preferred stock? Ans: 18.9%.
6. Occean corporation is expected to pay 3.50 taka next year, its growth rate is 8 percent; and
the stock now sells for 44 taka. New stock can be sold to net the firm 38.50 taka per share.
a) What is Occean’s cost of retained earnings?
b) What is Occean’s percentage floatations cost?
c) What is Occean’s cost of new common stock?
7. Occean’s cost of common equity is 16 percent. Its before-tax cost of debt is 13 percent, and
its marginal tax rate is 37 percent. The stock sells at book value. If the firm has long term
debt of 13000000 taka and 8500000 taka of common equity. What is Occean’s weighted
average cost of capital? Ans: 11.28%.
8. ABC Coping Corporation has 9 million shares of common stock outstanding and 120,000,
8.5 percent semiannual bonds outstanding, with par value of Tk.1000 each. The common
stock currently sells for Tk.34 per share and has a beta of 1.20, and the bonds have 15 years
to maturity and sell for 93 percent of par. The market risk premium is 10 percent, T-bills are
yielding 5 percent annual return, and ABC Coping’s tax rate is 40 percent.
a) What is the firm’s market value? What are market value weights of the firm’s capital
structure? Ans: 417.6 m, E = 73.28% and D = 26.72%.
b) If ABC Mining is evaluating a new investment project that has the same risk as the firm’s
typical project, what rate should the firm use to discount the project’s cash flows? (Note: use
WACC formula based on market value weights.) Ans: WACC = 13.95%
9. Aziz Industries has 6.5 million shares of common stock outstanding with a market price of
Tk.14.00 per share. The company also has outstanding preferred stock with a market value of
Tk.10 million, and 25,000 bonds outstanding, each with face value Tk.1,000 and selling at
90% of par value. The cost of equity is 14%, the cost of preferred is 10%, and the cost of
debt is 7.25%. If Aziz's tax rate is 34%, what is the WACC? Ans: 12%.
10. Suppose that ABC Inc. has a capital structure of 37 percent equity, 17 percent preferred
stock, and 46 percent debt. If the before-tax component costs of equity, preferred stock and
debt are 14.5 percent, 11 percent and 9.5 percent, respectively, what is ABC’s WACC if the
firm faces an average tax rate of 30%? Ans: 9.86%.
11. Tropa Industries has 3 million shares of stock outstanding selling at 17 taka per share and an
issue of Tk. 20 million in 7.5 percent, annual coupon bonds with a maturity of 15 years,
selling at 106 percent of par. If Tropa’s weighted average tax rate is 34 percent and its cost
of equity is 14.5 percent, what is Tropa’s WACC? Ans: 11.57%

25
12. Suppose that Deshbandhu’s common shares sell for Tk. 19.50 per share, are expected to set
their next annual dividend at Tk.0.57 per share, and that all future dividends are expected to
grow by 4 percent per year, indefinitely. If Deshbandhu faces a flotation cost of 13% on new
equity issues, what will be the flotation-adjusted cost of equity? Ans: 7.36%.

26